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The Question of Apportionability Has No Easy Answer

Few terms in state and local tax are more of a misnomer than “nonbusiness income.” It’s as if nonbusiness income would have no relationship to a business. In reality, though, nonbusiness income is part of a business’s total income; it is simply not apportionable income. Thankfully, many states and the Multistate Tax Compact now refer to business income as apportionable income and nonbusiness income as non-apportionable income. While that provides some clarity, the underlying definitions – and how states apply them – leave much to be desired.

States may only impose tax on the income of a business that is related to the unitary business conducted within the taxing state. This is called the unitary business principle and is considered the “linchpin of apportionability in the field of state taxation.” In essence, if a state wants to tax income from business activities outside its borders, it must determine how much of that income is related to the multijurisdictional unitary operations of the business – the business or apportionable income – and apportion that amount between the various jurisdictions. Items of income that are not related to the multijurisdictional unitary operations of the business – the non-apportionable income – are allocable to a single jurisdiction.

The characterization of income as apportionable or non-apportionable has been one of the more heavily argued topics in state and local tax. The problem is a lack of uniformity. Although the Uniform Division of Income for Tax Purposes Act provides definitions of what constitutes apportionable and non-apportionable income, states are far from consistent in applying those definitions.

Also, many states have interpreted UDITPA as having two alternate tests for determining business income: a transactional test and a functional test. The transactional test, which focuses on the nature of the income-producing transaction, has not been the subject of much controversy, but the functional test has been widely debated. Under the functional test, income that would not be business income under the transactional test might still be subject to apportionment if the income arises from an asset that serves an integral business function.

Still, despite court cases, elaborate tests, and legislative and regulative changes, many states use definitions that are destined for multiple defensible opinions. For example, some states define apportionable income as all income apportionable under the U.S. Constitution, and non-apportionable income as all income that is not apportionable income. Not particularly enlightening definitions, but states have found that broad definitions serve them better. This is especially true when trying to categorize income from the liquidation of a business as apportionable income.

Also, some states are rethinking types of income, such as passive investment income and capital gains that have historically been characterized as non-apportionable income. States are contemplating whether these characterizations are working any more or perhaps they believe re-characterizing certain types of income will generate more revenue. Broad definitions can accommodate changes over time, although for taxpayers, a change in the interpretation of apportionable income could have dramatic effects on the tax implications of certain transactions.

None of this is new, however, and it feels like a recurring problem in the administration of state tax systems. Definitions may be too broad, or interpretations can change without notice. It often seems like the rules are constantly changing. To make things even more complicated, the lack of uniformity among the states means that what constitutes apportionable income in one state might be non-apportionable income in another. While it means a constant flow of work for tax practitioners, taxpayers are left scrambling to keep up.

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